5.5 Analysis of Accounts

Part 1: Profitability

What is Profitability?

Profitability means measuring how much profit a business makes compared to something else — either the sales it earns or the money invested in it. Think of it as asking: "How good is this business at turning money coming in into actual profit?"

It is important to note the difference between profit and profitability:

• Profit is a fixed amount — for example, $5,000.
• Profitability is expressed as a percentage — for example, 25%. This makes it much more useful because you can compare it across different years or between different businesses, regardless of their size.

Why is Profitability Important?

Profitability tells us how efficiently a business is running. A business that earns high profit from relatively low sales or little invested money is performing very well. A business where profit is shrinking over time may have a serious problem.

Profitability matters to:

• Investors — They look at profitability before deciding where to put their money. Higher profitability usually means a better return on their investment.
• Directors and managers — They use profitability ratios to judge whether the business is improving or declining over time, and to set goals.
• Employees — A more profitable business is more likely to offer pay rises, bonuses, and job security.

Part 2: Liquidity

What is Liquidity?

Liquidity is the ability of a business to pay its short-term debts — meaning the bills and payments that are due very soon, usually within one year. These could include payments to suppliers, utility bills, loan repayments, or wages.

Think of liquidity like having enough cash in your wallet to pay for things right now. Even if you own a house worth a lot of money, if you have no cash on you today, you cannot pay for your lunch.

Why is Liquidity Important?

A business that cannot pay its short-term debts is described as illiquid. This is a very dangerous situation because:

• Suppliers may stop delivering materials the business needs to produce its goods.
• Banks may withdraw credit or overdraft facilities.
• The business's credit rating (how trustworthy it looks to lenders) will suffer.
• Creditors (people the business owes money to) may force the business to sell its assets to recover the money owed — or even shut the business down entirely.

This is why maintaining good liquidity is just as important as being profitable. A business can be profitable on paper but still run out of cash if it cannot collect money quickly enough.